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Conduct Risk: Compensation

Conduct Risk: Compensation

Nicolas Corry, Managing Director, nicolas.corry@skadilimited.co

It’s the time of year when the compensation for Financial professionals is brought sharply into focus. Regulators are driving for compensation to be linked to long term profitability and conduct, recognising that hard pay out structures and incentive schemes may encourage short termism. However significant gap risk persists. Sell side staff increasingly find that their compensation is pushed further down the line, with lengthy vesting periods, and the threat of claw backs to pay should staff be found guilty of wrongdoing (malus).

Across the street from the Traders and Investment Bankers, who capture most of the headlines, there are market participants with compensation models that are moving sharply in the opposite direction. Interdealer Brokers are a prime example of parties who’s compensation model is becoming harder. Their pay model has moved from salary plus bonus to one that is “eat what you kill”. Salaries have been switched for draws which are effectively small bonus advances, with quarterly bonuses determined from high hard percentages ranging from 35% – 65% of profit generated. This juxtaposition heightens the risk of trading staff directing business, and over trading, with the goal of sharing revenue generated with the broker.

Joint Ventures also pose a risk where other parties in a JV are compensated in a hard manner for business brought in. An example may be a broker, or hedge fund, charged with sourcing “cheap” packages of securities. Trading staff may be lured into turning a blind eye to less profitable, or even loss making trades at the expense of the trading book, if they are able to monetise activity through their relationship with a party within the JV who’s payout structure is hard.

We recommend our customers identify businesses using Interdealer Brokers (wide-spread) and Joint Ventures. They should establish what line of sight Front Office Management have over trading activity, and whether reviews/monitoring are in place to identify broker concentration risk, whether traders are awarding excess brokerage and whether this is appropriate. In the case of Joint Ventures, control functions should review the terms to judge whether there are opportunities for parties to extract up front revenue under the terms of the arrangement.

Conduct Risk: Colloquial Trading Practices

Conduct Risk: Colloquial Trading Practices

Nicolas Corry, Managing Director, nicolas.corry@skadilimited.co

Our customers constantly ask us where the next area of focus for Regulators will come from. Our predictions are that regardless of the product or market, poor conduct will be at its heart. The Fair and Effective Markets Review devotes a large part of its scope to the subject of Conduct Risk. Conduct Risk emerges from a number of powerful drivers which are challenging to define, recognise and control. A key challenge Control Functions face is how to manage Conduct Risk effectively without constraining Front Office innovation and creativity.

Skadi Limited has defined an area of risk: Colloquial Trading practices. We define these as practices traders use in their day to day activity, at best, not governed by rule structure, at worst, unknown and unrecognised by outside observers which include Management, Control and the Regulators. Examples are Last Look (now identified), No-post Trading, Grey Market Trading.

No-post trading is the practice whereby traders ask the Inter-dealer Broker and the Counterparty on the other side of a trade to agree not to broadcast the trade to the wider market place, preserving the secrecy of the transaction. Justifications for this may include an instrument being highly illiquid, when knowledge of the transaction may impact the market price for a security. The practice could be misused however. Risks include front running, creating a false market.

Grey Market Trading is dealing in a new security prior to its terms being fixed. Grey Markets are intrinsically linked to the success of a new issue placing, it is paramount therefore that members of syndicate do not trade in the Grey. Securities trading above issue price will attract orders into the book, it may also be attractive to sell into the Grey Market price to reduce the price of a security to protect the Syndicate from accusations that the terms offered to the market were too generous to the disadvantage of the Issuer. Grey Market Trading mainly occurs via the Inter-dealer Broker market, and a Grey Market may develop over a number of days, it can be difficult to track trading activity as the securities generally are not set up until the terms are known, allowing trades to be parked for a few days, and booked out at a later stage. To date we have not found regulation covering Grey Market Trading, therefore the practice is also at risk from ethical drift as new traders over time may not be aware that their participation as a Syndicate member is wrong.

We recommend our customers establish to what extent “Colloquial Trading Practices” are recognised by Front Office Management. Whether the practices have been reviewed for their application in the current market environment. c.f. last look trading borne out of a legitimate historic need but now no longer acceptable to advances and changes in the market place. Audit and Compliance need to ask Front Office to demonstrate and provide justification for their legitimate use and assess whether they are appropriately controlled.

Taking a forward look today, could help prevent a “Last Look” tomorrow.

Courtsiders at Tennis – why not the financial markets?

Courtsiders at Tennis – why not the financial markets?

Nicolas Corry, Managing Director, nicolas.corry@skadilimited.co

At 22 years of age, Dan Dobson was paid to travel the world and watch tennis. Was he a reporter? Well, kind of. Last year Dan was arrested at the Australian Open tennis tournament for Courtsiding. Dan’s job was to report back live data to betting syndicates on how the tennis was progressing at the tournament. The aim being to provide the gamblers with an edge by reporting data faster than it could be received by the counterparties they were betting against. In an interview with the BBC Dan explained how he reported information. Using a simple device in his trousers he relayed scores back to London. Pressing one for Djokovic, two for Murray for example.

This story intrigues us at Skadi Limited. Often in the world of sports betting there are a number of parallels with the financial markets, and indeed a number of participants in the financial markets also play the sports markets in their spare time. Therefore it is plausible to see that a practice in one market could be imported to another. The question is whether “Marketsiding” is a plausible risk, and if so what form might it take?

We consider it to be a plausible risk as the practice is simple, and more complex practices/frauds have been unveiled which have similar goals. Consider the Merrill Lynch Squawk Box case of 2009 where retail brokers permitted day traders to listen in to orders they held, by simply leaving their telephones next to the squawk box for the trading day. Nowadays we receive warnings about the risks of using webcams. How much would a syndicate pay for access to the webcam on the desk of the head of block trading at Barclays one wonders?

There are also interesting parallels between Courtsiding and some of the activities of High Frequency Traders. Courtsiders attempt to relay information before it reaches the broader gambling market. High Frequency Traders invest significant capital in infrastructure and feeds to process orders faster than the broader market. But more simply could syndicates place persuade personnel located on a dealing floor, to relay information on orders held by a trading desk, allowing parties to position to take advantage of that flow? It surely couldn’t happen, could it…?

Equity research under pressure #research #bankculture

Equity research under pressure #research #bankculture

William Vincent, Senior Consultant, william.vincent@skadilimited.co

UBS has been caught up in a political row in Australia after it produced a research report on the privatisation of a New South Wales electricity utility, a deal in which it is acting for the seller. What happened is that UBS put a report entitled “Bad for the budget, good for the State”, then changed the title to, simply, “Good for the State”. The opposition Labor (sic) party is claiming that this was the result of direct interference from the ruling Liberals.

To which a rational first response is “so what?” After all, Australia is a long way away, and Australian politicians are renowned for fighting like starved rats in a barrel, so why should anyone bother about this? In fact, while the details are not terribly important, this case, coming on top of several others, illustrates equity research is still vulnerable as it tries to square the various circles of adding value to its users, not offending the investment bankers and their clients, satisfying ever-more intrusive regulators, all the time while facing a crippling squeeze on revenues.

Two instances over the past year or so indicate the scale of the problem. First, last summer UBS (again) came under fire, this time in the UK. A UBS analyst had produced a report on Saga, which UBS had helped to float a few months earlier, with an Underperform recommendation and a target price some 4% lower than the sale price. The result was a chorus of criticism, notably from the UK Shareholders’ Association, which was quoted in the Financial Times as saying, “It’s all wrong for them to value the company at a high level and then drop it,” while an unnamed but — according to the FT — influential fund manager described the incident as “very, very strange.”

So, this argument goes, it’s wrong for an analyst to set a price target (which, incidentally, has proved to be accurate) independently of the bankers, rather than try to ramp up a price simply because his house had a role in the flotation? Clearly, no-one has told the regulators, who have spent much of the past fifteen years setting and enforcing rules that give analysts no choice but to act in a way that the UK Shareholders’ Association believe is “all wrong”. In short, UBS’ analysts were attacked for doing exactly the right thing – a classic case of damned if you do, damned if you don’t.

Second, there was the case in the USA last November when Citibank was fined a cool $15m for inadequately supervising equity analysts. The specific issue was that an analyst told people at a dinner that he’d short a stock on which he had an official Hold rating. It is possible to think of reasons why analysts might feel there is little wrong with this position, for example a share that is expected to perform in line with the market over a twelve month timeframe might well be over-bought in the short-term, nonetheless the regulator took tough action.

These cases, and others, illustrate how difficult it can be for research to operate today. What should banks now do – send a compliance person to every analyst dinner, lunch or post-work beer with a client? The only answer is for research to have absolutely clear, transparent and detailed policies for every regulatory contingency. Banks must be able to convince the regulators that every analyst is aware of the rules, receives regular training in them, and understands the consequences of not following them. Research management and the analysts under them must understand that compliance is not optional, and that the penalties for even what seem like minor breaches will be severe. Needless to say, this will not go down well with the notoriously egotistical and touchy research community, but the price of being caught in financial and reputational terms is so high that no alternative exists.

The problem is that heads of research aren’t necessarily experts on the regulations, and in any case are likely to be caught up in the day to day cat-herding exercise that is managing analysts. The compliance and other professionals who do understand the regulations are not analysts, and thus don’t necessarily know the pressures inherent in the job, and they run the risk of being seen as “the enemy” by the people at the coalface, with all that that implies.

Meanwhile, Frost Consulting has estimated that total spending on equity research fell to about $4.8 billion in 2013 from $8.2 billion in 2008, with a further cut, to around $3.4 billion, expected by 2017. London is likely to be hit especially hard, because new rules will effectively prevent payment by the buy side for research that is not “substantive.”

Many banks will almost certainly have to axe much, if not most, of their current output, and with it the people responsible for it. The whole ethos of research will have to change, from churning out yet another quarterly results analysis or big, bland sector review to doing radical stuff, like producing readable, original, tightly argued research that produces recommendations that actually make money.

All in all, therefore, research is facing a period of fundamental change. Those that get it right have the opportunity to clean up in a market where much of the competition will be squeezed out. Those that do not will be the squeezed.

Issuance Issues #bankculture #issuance

Issuance Issues #bankculture #issuance

Nicolas Corry, Managing Director, nicolas.corry@skadilimited.co

Last week Bloomberg writer Zeke Faux’s piece on Death Spiral Financing allowed a small chink of light to shine on the Private Issuance market. Death spiral structures are not new, and generally appear to be above board, but it is hard not to recognise the risk and damage they pose to investors in a company that chooses to source finance in such a manner. Private transactions tend to be by their nature private. They tend to be structured between (one hopes) sophisticated parties that are able to shoulder the burden of reduced disclosure and consequent increased risk. One wonders though what consideration is given to other stakeholders? Smaller shareholders, employees, customers, suppliers to mention a few.

In the Public Issuance market recent reporting by the Financial Times offers insight into the activities which may occur during the book building process. While activities such as order inflation may be known, the allegations made regarding fake order creation to win more paper, will shock many.

It seems clear that Control Functions should review their organisations’ issuance procedures, with careful attention given to where business lines meet, such as at Syndicate and in the Private market, where transactions are handled together between banking and markets. These areas represent gap risk, as consideration may have been given to each business individually, but not together as a whole.